February 16, 1998 – I think it was Helmut Kohl who compared the political process to sausage making – by advising facetiously that in politics like sausages you really don’t want to know what was put in to get the desired result.
While this adage may work well for politics and sausages, it doesn’t work at all when creating money because money is too important. In the case of money, the desired result – the widespread acceptance of the unit of account to enable it to circulate current – depends on its composition, which should be as transparent and open as possible. The more people know about the composition and therefore the inherent safety of any currency (presuming it is safe), then the better it will circulate.
People generally take more care about what they put into their pocket and bank account, than what they put into their stomach. So the composition of the Euro – the proposed new single currency of the European Community – must be examined in order to make some basic conclusions about whether it will circulate freely and with widespread acceptance.
Currencies now circulate largely because of legal tender laws. It used to be that currencies circulated because of what they were (precious metal or at least a promise to pay precious metal if redemption was requested), but those days are long gone. Now currency circulates largely by force and compulsion.
Therefore, when the redeemability of national currency into precious metal was ended earlier this century, the composition of currencies became even more important.
Recognizing that currency is a liability of the central bank (cash currency) or the commercial bank where the currency is on deposit (in checking or other deposit accounts), the quality of that currency is only as good as the assets of those institutions.
Therefore, the composition of the Euro – the assets that give it value for use as money – are of utmost importance, particularly to non-Europeans. They aren’t bound by legal tender laws, so non-European use of the Euro will be by choice, not compulsion. So will they choose to use the Euro? The answer to this question may come from examining the Euro’s proposed international reserves. Further, it will be useful to examine these reserves by comparing the Euro to the US Dollar. After all, the Euro and the Dollar do have striking similarities.
They both are a single currency that circulates within an economic bloc (the United States and the European Community respectively) because of legal tender laws. The Dollar also circulates internationally, which is one of the stated goals of most politicians creating the Euro. Therefore, a comparison of the US Dollar to the Euro can be meaningful, and the composition of each currency can be examined using the foreign reserves.
The United States has $135 billion in foreign reserves, comprised of Gold ($78 billion at the current exchange rate of $300) and everything else ($57 billion). Therefore, Gold comprises 58% of the foreign reserves backing the Dollar.
Right now the Euro is still a distant figment in the minds of various European politicians, but they have already let it be known that they would like the foreign reserves of the Euro to be Ecu 50 billion (the Ecu is the fictitious and some say phantom accounting unit of the European bureaucracy in Brussels because the Ecu does not really circulate in economic activity), which at the current exchange rate equals about $55 billion.
Why Ecu 50 billion? Well, we don’t really know because the bureaucrats behind the Euro haven’t disclosed how they came to agree on this figure (and we probably don’t really want to know as Herr Kohl has warned us). In any case, Ecu 50 billion is the number. Now here is where some interesting speculation and various surmising come into play.
It is well accepted that only 11 of the 15 member countries of the European Union will adopt the single currency when it comes into use. The other four members either cannot meet the financial criteria established to create the single currency and/or do not want to join.
These 11 countries have between them a weight of Gold totaling $99 billion at current rates of exchange. If this Gold was transferred from the member countries to the new European Central Bank to hold as foreign reserves, and if the 11 member countries also turned over between them some $55 billion in foreign currencies as the non-precious metal component of the foreign reserve, we get a surprising result. The Gold component would equal 64% of total reserves, surprisingly close to the 58% Gold composition of the foreign reserves supporting the Dollar. Why is this important? Two reasons.
First, it answers the question whether the Euro will circulate outside of Europe and be held by non-Europeans as an alternative to the Dollar. Look at this question by suggesting the Euro will have no or little Gold in reserve. In that case, the foreign reserve of the Euro would consist principally of Dollars. But if the Euro is based largely on Dollars, why even hold the Euro? Wouldn’t it make more sense just to hold the Dollar instead? Of course.
Therefore, for the Euro to be a viable international currency, it must have viable foreign reserves. Using the Dollar as a role model, these reserves must consist principally of Gold, and to a lesser extent national currencies. But a large Gold component is important for the second reason.
If the foreign reserves of the Euro were made to look like those of the Dollar, the remaining Gold in European central banks is needed. Consequently, Gold reserves for the Euro comparable to the Dollar would mean no Gold was available for dishoarding by European central banks. This result would be important to the Gold market and the price of Gold, lifting considerable uncertainty from the weight of Gold controlled by the 11 central banks likely to join the new single currency.
Within Europe, the Euro will sink or swim on whether the legal tender laws forcing it into circulation will be accepted (which remains open for question because the polls show most people are against giving up national currencies in place of the Euro). But outside of Europe, the Euro will sink or swim on whether it is a good currency, thus the composition of its foreign reserves is of utmost importance.
If the Euro is to circulate internationally in competition with the US Dollar, then it must have foreign reserves as good as the Dollar’s foreign reserves. Therefore, contrary to popular thinking, the Euro may end up with a large Gold component, which would be a very bullish development for the Gold price.